An ESRC Research Group

The support of the Economic and Social Research Council
(ESRC) is gratefully acknowledged. The work was part of the
programme of the ESRC Global Poverty Research Group.
Insurance for the Poor?

Stefan Dercon, Tessa Bold and Cesar Calvo*1

2007

Abstract
Uninsured risk has substantial welfare costs, not just in the short run, but also in terms of
perpetuating poverty. This paper discusses the scope for extending insurance to the poor,
drawing mainly on examples from Latin American and Caribbean countries. It is argued that
insurance provision to the poor could play an important role in a comprehensive system of
protection against risk, including other ex-ante measures such as promoting credit and savings
as insurance, as well as a credible overall ex-post safety net. Insurance provision is best
promoted via a partner-agent model, in which a local finance institution with close links to
relatively poor communities teams up with an established insurer to deliver low-cost, tailored
products, such as life, health, property and weather insurance. An essential role of the
government would be to promote insurance provision to the poor by a relevant regulatory
framework favouring MFIs within a partner-agent setup, and to provide overall credibility to the
overall system of social protection. The paper also argues for the involvement of local
indigenous risk-sharing and finance institutions as intermediaries to maximize the ability to
reach the poor and the overall welfare benefits.

* University of Oxford
Contact: stefan.dercon@economics.ox.ac.uk

1
This paper is based on work initially financed by the Inter-American Development Bank and by the
World Institute of Development Economics Research (WIDER). I would like to thank Luis Tejerina for
insightful comments.

1
Introduction

Households in developing countries are exposed to high risks, with important consequences on
their welfare. They range from individual-specific (illness, theft or unemployment), to
economy-wide risks (drought, recession, etc.). It has long been acknowledged that these shocks
have important implications, not least for the poor, including short-term effects on consumption
and nutrition, resulting in calls for and the establishment of safety nets or other social security
mechanisms. This paper goes beyond this view by arguing, first, that the costs related to these
risks are much higher than a simple consideration of short-term costs, and secondly, that
expanding insurance provision for the poor could be an important instrument with substantial
long-term welfare benefits. To illustrate this possibility, we use examples, mainly from Latin
America, starting from a consideration of how risk affects the poor and the ways in which they
respond to it. The paper discusses the most promising products, institutional setup and the
required regulatory framework to successfully expand insurance for the poor. We want to
emphasize that expanding insurance product should only be viewed as one part of a
comprehensive expansion of protection of the poor, and not a panacea for all risk problems
faced by the poor.

In addressing the case for extending insurance to the poor, a number of key questions need to be
answered. First, is risk prevalent – and what are these risks? Thinking about the design and
promotion of specific insurance products requires a careful understanding of the risks the poor
face and their consequences. Recent surveys have highlighted the variety of risks the poor face
(Morduch, 1995; Townsend, 1995; World Bank, 2000; Dercon, 2002; Fafchamps, 2003). Some
of these risks are relatively straightforward to insure—such as funerals, serious health
problems, unemployment—while in the case of others—a country-wide recession or crime—
several factors come into play. Any discussion about insurance for the poor will need to
acknowledge the shortcomings of an insurance-related approach and the need for alternative
mechanisms to deal with the implications of particular shocks. This paper argues that there is a
need to think in terms of complementarities with other mechanisms to reduce and to cope with
risk, including e.g. safety nets in the form of employment schemes or social funds. A related
issue is that much of the existing literature related to the risks facing the poor tends to focus
largely on rural settings, mainly in Africa and Asia. Part of the reason is that worldwide, most
of the poor live in rural areas and drought or flooding risks are the most commonly studied
when considering the impact of risk on the poor. The relatively higher urbanization rate of other
parts of world, not least in Latin America, implies that urban risks are also crucial for our
discussion. Section 1 will take up these issues in more detail.

The poor do not just undergo the high risk in their environment, rather they actively try to
manage it and cope with its consequences. A study of the strategies to manage and to cope with
risk helps understand the implications of risk for welfare as well as for the design of policy
responses, including insurance. Much research was conducted in recent years on these
strategies and their implications, even though more work is definitely needed. These strategies
typically involve households trying to shape the risk they face by changing their activity and
asset portfolios so there is less risk involved. A typical example is diversification of activities,
whereby imperfect correlation between the return to activities is exploited to reduce overall
exposure to risk. A key implication is typically that mean return is forgone when moving to a

2
less risky portfolio, which effectively increases or perpetuates poverty in the long run. Other
strategies involve risk-coping mechanisms, such as trying to overcome missing or imperfect
credit and insurance markets by entering into ‘self-insurance’ via savings, in which assets are
accumulated in good years to be depleted in bad years, or entering into informal mutual
assistance arrangements within families or neighbourhoods. Most evidence suggests,
nevertheless, that risk management and coping is rather imperfect, and shocks result in
substantial fluctuations in welfare outcomes, undermining also the asset base of households for
future wealth creation, not just in terms of physical and financial assets, but also nutrition and
human capital (Morduch, 1995; Dercon, 2002; Dercon and Hoddinott, 2004).

The evidence that risk strategies result in lower long-term income and that shocks significantly
undermine the ability to grow out of poverty has important implications for the welfare costs
involved in risk. The overall result is not only fluctuations in welfare levels, but also a loss of
efficiency in that the poor are induced to use their assets less efficiently than the rich.
Theoretical models such as the one by Banerjee and Newman (1993) build on this feature to
show that risk may well result in poverty traps, a situation in which those who cannot escape
poverty by their own means end up living in permanent poverty, even if other sectors of the
economy are growing. The implication is also that there is no trade-off between equity and
efficiency when measures are taken to avoid those poverty traps. In other words, there is a case
for providing insurance at subsidized rates so that some do not slip into poverty. Section 2
further expands on this point.

Although public policy and interventions can reduce risk (even if it is by means of subsidies),
this does not necessarily settle the issue about the appropriate form of such interventions.
Indeed, it still would need to be shown that insurance is the right solution. In section 3 the case
for strengthening insurance and insurance substitutes is be made, but it is also acknowledged
that insurance products can be costly and, more importantly, they cannot solve all problems
facing the poor. Alternative (complementary) measures are discussed as well, not least in
response to the realization that some economic shocks or social and political risks usually
cannot be insured by insurance markets or at least that alternative measures may be more cost-
effective. Still, the scope for insurance products for the poor remains strong.

Section 4 discusses general issues related to the design of insurance for the poor. A key issue to
be considered is that one must ensure that the poor are effectively reached, which suggests the
need to involve local and grass-root organizations with established links with the poor. Equally
important is that the system should be able to provide a cost-effective service and be
sustainable. Insurance provision is a specialized service, and should involve private and
possibly public sector institutions with the experience and financial capacity to operate such
schemes. A ‘partner-agent’ model is most likely the most effective institutional arrangement.
Section 5 then discusses possible products, addressing the risks that are most suitable for
insurance-based protection, focusing on life, health, property and weather insurance. Section 6
centers on the role that different institutions should play, and focuses on the required regulatory
framework. Section 7 analyzes the potential role of local social institutions already providing
informal insurance.

3
Risk and the Poor
There are a number of ways of classifying risks faced by the poor. Two issues are relevant for
our purposes: the extent to which the poor are affected by these sources of risk and the extent to
which developing more insurance is an appropriate response. To discuss the first point, the
covariance of risks across a population and the frequency of risks over time are relevant here.
Insurance contracts are most easily offered if risks within the relevant population are not
covariate – so that only some put in a claim at the same time. Furthermore, insurance for rare
and infrequent events is also typically more difficult to offer. Taken together, if these rare
events are also covariate, i.e. typically occurring to large population at the same time (such as a
flood, hurricane or an economic recession), then insurance contracts are most difficult to offer.
These considerations are important for the rest of this discussion.

It is important to bear in mind that, when looking at how the poor are affected by risk, our
observations on which risks affect living standards most are largely based on evidence that
takes into account the mechanisms people use to manage and cope with risk. For example, it
may be the case that the lack of old age security is not quoted as a serious risk in a particular
poor community since the community is still using intergenerational transfers as an effective
mechanism to support the elderly. Furthermore, it may be that the development of market-based
pension funds may crowd out these community-based mechanisms. It has been shown that this
may even lead to some being more exposed to risk than before (Attanasio and Rios-Rull, 2000).
This has two important implications: first, we need to carefully study the way individuals,
households and communities cope with risk and secondly, problems of crowding-out and their
possible welfare implications should be discussed in more detail. The third and fourth sections
analyze these points further.

Turning to the typology of risks, in recent years a number of studies have highlighted the risks
facing the poor. Nevertheless, the focus has largely been on data from South Asia and, more
recently, from Africa (Morduch, 1995; Dercon, 2002). One key difference between these
regions and Latin America and the Caribbean is the degree of urbanization, more specifically,
the substantial urban nature of poverty. Whereas poverty is mainly a rural phenomenon in
Africa and Asia, the urban share of population in Latin America and the Caribbean is large
enough to ensure that urban areas account for most of the poor. For example, in Latin America,
Chile and Brazil are extreme cases where 84 percent and 70 percent, respectively, of the poor
belong to the urban sector.

Urban poverty is different from rural poverty. For instance, there are risks that are specific to
the urban poor but not to the rural poor, and vice versa, or at least risks that have a different
intensity than in a rural setting.2 Examples are sanitation and public health risks related to
overcrowding, or risks related to crime. Thus, an analysis of risk and insurance for the poor in
Latin America and the Caribbean will necessarily diverge in some way from most previous
studies based on African or Asian experiences and focused, almost exclusively, on risks in rural

2
It should be pointed out here that the urban poor face different risks, not more (or less) risks. For example, in an
LSMS in Peru in 2001, 30.1 percent of urban households reported to have suffered a shock. In the rural sample, this
percentage was 29.6 percent (Chacaltana, 2002).

4
areas. The focus here will not be on urban risks only, but an attempt is made in this discussion
to give at least equal weight to both types of settings.

Few studies have systematically tried to record the sources of risk faced by the poor.As part of a
more extensive World Bank study on poverty in Guatemala, the analysis by Tesliuc and Lindert
(2002) provides a unique insight into those sources and their consequences in this country,
based on a specifically designed household survey combined with focus group interviews,
conducted in 2000. It should be noted that Guatemala is one of the most rural economies in
Latin America, presenting the lowest percentage of urban poor, so their findings need to be
supplemented by other sources for a more complete picture. Although no serious economic
crises or natural disasters occurred in 2000, Tesliuc and Lindert found that about 53 percent of
the households interviewed reported one or more shocks: 23 percent mentioned a ‘natural’
shock (from pests to forest fires and floods), 17 percent reported an economic or other man-
made shock, and 13 percent reported both. The commonly reported shocks were agricultural
related but many different types of shocks were identified (Table 1). Some of these shocks were
largely ‘rural’—pests, lost harvest and drought are the obvious ones—, while others are
common in urban areas—including crime and job losses, which had more than double the
incidence in urban areas. Accidents and floods have similar incidence in rural and urban
settings, with no apparent differences in the overall reported incidence of shocks across both
areas. Other studies in the same period confirm the high incidence of shocks. For example,
Gaviria and Pages (1999) report that in the first semester of 2000 36 percent of urban
Guatemalans reported a shock causing loss of income. A study on Peru (Chacaltana, 2002)
reported about 30 percent of households facing a significant shock to income or wealth in 2001.
In short, all available evidence suggests that shocks are prevalent in both rural and urban
households in Latin America and the Caribbean.

The study by Tesliuc and Lindert (2002) has other striking findings. First, in 2000, all these
shocks were typically idiosyncratic, i.e. only a sub-section of a local population was affected. It
should nevertheless be recalled that this is largely a year without serious ‘large’ and covariant
shocks. In fact, during the last five years, some shocks had a much higher incidence, including
hurricanes (Hurricane Mitch was included in this period), with 44 percent reportedly being
affected, while forest fires hit 17 percent at least once over a five-year period. These types of
risks are largely covariant, affecting typically whole communities or neighbourhoods. Secondly,
there was a rather high incidence of households being affected by more multiple shocks – a
phenomenon they call ‘bunching’ of risk, which may exacerbate the consequences of shocks.
Agricultural shocks, such as drought and pests, tend to come together, as are economic shocks,
such as job losses and accidents or death of a breadwinner. They also find that the poorest are

5
more affected by shocks. In terms of asset or welfare loss, the poor are typically hit the harder.
This is especially the case for shocks related to agricultural risks.

In Tesliuc and Lindert (2002), health shocks were not analyzed in their survey, which does not
mean that they are irrelevant. For example, in a rural sample in Mexico (World Bank, 1995,
reported in Ibarra, 2003), it was found that about 48 percent of households reported a shock in
wealth or welfare related to a drop in yields (largely due to weather-related events), while the
second main cause was illness of the farmer or a member of its family (reported by about 15
percent of households). This is consistent with surveys from across the world where illness is
typically the second most frequent risk in rural settings after crop failures (see Dercon, 2002),
and before many other risks (such as loss of livestock, crime or fire).

In sum, a discussion of the risks faced by the poor in Latin American and Caribbean countries
will need to consider those risks with high incidence and with serious consequences. ‘Natural’
risks are clearly at top of the list, but not only for rural settings. Some are obviously rural, such
as those related to harvest losses due to drought or pests, but floods or hurricane risks, and other
large-scale natural disasters, are also relevant to urban settings. Data on the impact of large-
scale natural disasters over a 30-year period (table 2) suggest that their impact on households –
ranging from death, injury, homelessness and physical damage – is substantial.

Other risks, not least health, disability and mortality risks, should be given center stage as well.
Health care costs cause significant stress among the poor. In fact, in one of the most careful
studies on risks faced by the poor in an urban setting, illnesses are the most common shocks in
the SEWA data from India (Chen and Snodgrass, 2001). In Peru, the LSMS of 2000 shows that
health expenditure adds up to 8.9 percent of total monthly expenditure of the poor when a
household member is ill.

Illness is a more pervasive risk in areas where public health services are inadequate. Careful
qualitative work for the World Development Report 2000/01 for a number of Latin American
and Caribbean countries suggests that both the urban and the rural poor feel they have little
access to good quality health services, although the issue is mentioned more frequently by the
latter (World Bank, 1999). According to the LSMS from Peru, 46.8 percent of the urban poor
has access to a doctor, while this percentage falls to 39.6 percent among the rural poor.

6
In the case of disability, illness creates additional health care costs, but also a permanent effect
via the loss of income-earning capacity. Even a temporary disability may result in job loss, the
low-income period may last until the household member finds a new job. This is especially
harmful to the urban poor, as unemployment is a greater threat to them. The death of a family
member brings about grief and significant economic costs. Some of them are one-off outflows
(burial costs) while, more importantly, others are permanent (loss of a source of income).

A number of largely economic risks, such as job loss and lower income—, requires attention as
well. Qualitative surveys on perceived risks stress the central importance of the wage labor
market, not least in urban areas (e.g., Zaffarino, 1999; World Bank, 1999). A related risk is
caused by relative price changes and general inflation. Urban households are typically much
more exposed to these risks, since they rely more on the market, a fact Moser (1998) calls
‘commoditization.’ For example, it is easier for the rural poor to withdraw from the market
during inflation spells. In Peru, 13.8 percent of the urban households considered the economic
crisis as a shock in 2001, while only 2.8 percent of rural households did so (Chacaltana, 2002).

Finally, a discussion of risks faced by the poor needs to address some crucial ‘social’ risks,
including crime and lack of protection and rule of law. One of the key findings of the
qualitative studies as part of the World Development Report 2000/01 was that crime especially
affects the poor, which is, for the most part, linked to a poorer protection by the police and
judiciary system.

Brazilian favelas are an evident and extreme example of the threats crime imposes on the urban
poor. In urban areas in Argentina, “insecurity is constant and daily. (…) There is more
insecurity (…) in the slums, because they do not have material resources to face insecurity nor
support from the government (…) ‘The police does nothing’” (World Bank, 1999). In rural
villages, “security is not mentioned [as an issue]. (…) Their perception of security is influenced
by the news received from big urban centres: ‘They have everything but they are worse because
of crimes and drugs; we sleep with open doors here in the inland’” (World Bank, 1999). The
perceptions of these risks on the part of the poor are often closely linked to the absence of
property rights and the rule of law because of poor enforcement or even abuse by police or the
judiciary system. In particular, lack of legal ownership exposes the poor to sudden losses as the
authorities force them to leave their homes, or to plain abuses from corrupt officers. In
Argentina, the urban poor complain that ‘not only they [policemen] do not protect us, but they
also chase us and treat us badly’ (World Bank, 1999). Similarly, theft is reportedly as a
constant threat to the assets of the poor, whose neighborhoods have usually no police
protection.

(2130 words)

Market Failures and Household Responses to Risk
If these risks are substantial and the consequences are as serious as suggested above, the
question is why insurance markets are not offering insurance contracts to the poor. There are a
number of reasons why this may not occur. First, the usual information asymmetries apply.
Insurance contracts are exposed to adverse selection (hidden information) and moral hazard

7
(hidden action). In particular, they have been pointed out as the cause for the failure of crop
insurance systems (e.g., Braverman and Guasch, 1986; Binswanger, 1986). Similarly, health
risks are often hard to insure in a comprehensive manner, as are substantially covariate risks,
such as natural disasters or economic recession. However, it remains to be explained why these
asymmetries could be more perverse when policyholders are poor. In fact, they also plague
contracts in more developed markets.

Insurance providers mitigate information asymmetry by promoting group insurance (against
adverse selection) and by requiring co-payments and deductibles (against moral hazard).
Although insuring large groups is a feasible strategy, co-payments and deductibles may well
discourage the poor from buying the product. In any case, these payments and deductibles will
probably need to be lower than the values needed to separate ‘good risks’ from ‘bad risks’ (the
so-called second-best separating-equilibrium values). As contracts will still allow for significant
moral hazard, insurers will require high premiums and discourage the poor.

A related issue is that as the poor do not usually participate in the formal economy, formal
insurers also face enforcement problems and/or the poor confront extra costs. For example,
claiming for home insurance when there are no formal titles to land or homes imposes extra
verification costs, which discourages firms from offering contracts to the poor or makes them
less attractive. Similarly, the assets of the poor may be of relative low value, so the transactions
costs involved in valuation would be relatively high relative to the size of the contract. Costs
related to birth and death certificates may make insurance contracts less attractive to the poor as
well.

Supplying the poor with insurance implies further high transaction costs. For instance, micro-
credit experiences suggest that the poor find it easier to deal with frequent repayment in small
instalments. 3 This suggests that payments of premiums may also ideally occur in small
instalments, adding transaction costs to insurance provision.

Furthermore, it has been suggested that the poor sometimes have difficulty in properly
understanding their rights in insurance contracts. McCord et al. (2001) report several cases
where the poor did not file their claims after being affected by an event covered by their
policies. In other cases, some policyholders expected coverage beyond the scope of their
contract.

Finally, many of the most serious risks faced by the poor may well be covariant, and therefore
not easily insured by an emerging insurance market. The fact that a sizeable part of the
population is dependent on agriculture, and that macroeconomic instability is substantially
higher in developing rather than in richer countries (resulting in serious covariate shocks in the
economy) is bound to limit the emergence of private insurance focused on poorer segments of
the population.

3
In fact, Armendariz and Morduch (2000) argue that theoretical literature on microcredit has exaggerated the focus
on joint liability and dynamic incentives, and neglected the importance of the repayment schedule. This comment is
bound to be relevant for insurance provision as well.

8
The lack of market-based insurance could in principle have been compensated for by ‘social
insurance’ – or public sector-based insurance provision as part of broader social security
programs. In practice, the coverage of these programs for the poor is minimal in most Latin
American and Caribbean countries. For example, a recent review of Guatemala’s social
insurance system concluded that the “system provided minimal coverage of the population,
risks financial crisis, faces allegations of corruption and is regressive” (World Bank, 2003).
The Instituto Guatemalteco de Seguridad Social (IGSS) covers workers in the formal private
and public sectors only, and runs a number of programs. Programs analyzed, such as the
accident-maternity-sickness (IVS) program, were shown not only to be in deficit but also
regressive in terms of the incidence of benefits.

The lack of formal insurance or social insurance systems does not mean that the poorare passive
toward the risks they face. Much of their livelihood is centered around ways to reduce, mitigate
and cope with risks. The poor use risk management and risk coping strategies to alleviate risks.
Table 3 describes these strategies and their shortcomings. By risk management we mean that
they try to reduce the exposure to risk or mitigate the risk of some income sources by
combining them with others. Diversification of crops and other sources of income is one typical
example. Other common strategies involve migration and relative specialization in low-risk
activities, even at the cost of lower returns. Risk-coping strategies effectively try to smooth
consumption given income fluctuations linked to risk. These strategies include self-insurance,
i.e. building up suitable liquid assets in good years that can be depleted during a bad year. An
alternative strategy is to enter into informal ‘risk-sharing arrangements,’ i.e. informal insurance
arrangements based on reciprocal gifts or contingent credit.

Risk management and coping strategies are always present in the life of the household.
However, if a serious crisis occurs, households resort to more extreme actions, survival
strategies, i.e. ‘emergency’ actions to be taken when a reduction in income is unavoidable. See
table 4 for a summary of such strategies. More information can be found in Dercon (2002),
while the Social Risk Management Approach is discussed in Holzmann and Jorgensen (2000)
and in World Bank (2000).

9
Table 3. Risk Management and Coping Strategies

Strategy Examples Shortcomings
Managing and reducing risk Crop diversification Sacrifice of expected
resulting from changes in Specialization in low-risk income
sources of income activities
Migration of some
members of the household
Asset management Savings as self-insurance Lack of suitable saving
assets (risky or bulky
assets, insecurity)
Focus on liquid, less
productive assets
Long building-up time
Covariance in asset price
and income
Informal insurance Reciprocal gifts/loans from Incomplete protection
friends/relatives Vulnerability to covariant
risks
Market-based Insurance Typically not available

Table 4. Survival Strategies

Strategy Examples Shortcomings
Changes in sources of income Child labour Sacrifice of human capital
Asset management Selling/pawning of Long time to replace them
real/productive assets
Informal insurance Charity Incomplete protection
Vulnerability to covariant
risks
Market-based Bank loans for Usually not available
consumption credit

A few striking conclusions emerge from the empirical literature on this issue. First, households
cope with risk by using income-based strategies – such as diversification of income sources –
and assets for buffering consumption. Informal insurance and credit is also used, but only in a
relatively limited number of cases. These strategies are not without cost. As has been widely
documented, both income- and asset-based strategies imply efficiency losses in the generation
of income, and thus may lead to poverty traps (e.g., Rosenzweig and Binswanger, 1993;
Rosenzweig and Wolpin, 1993; Dercon, 2002).4 Lack of formal or informal insurance forces
households to choose a safe portfolio of activities and assets, which typically implies a lower
mean return. The poor have no access to insurance, and lack of insurance precludes the poor
from taking risks and increasing their income, thus perpetuating their poverty. The process is
exacerbated since, asset holdings are difficult to rebuild after they are depleted. In emergency

4
It is worth noting that most studies focus on poverty traps in the rural sector. Hence, the effect of risk exposure on
urban investment decisions remains to be explored. This research is especially relevant for Latin America.

10
cases, households are also forced to sacrifice human capital, as is the case when children drop
out from school and start working (Pizarro, 2001). In Peru, Jacoby (1994) finds that “children
from households with lower income (…) and greater childcare responsibilities begin
withdrawing from school earlier.” In urban areas, issues of privacy in the household arise, as
families rent out rooms, or children come back to the parental house in order to rent out their
own house (Zaffaroni, 1999). In fact, after analyzing data on Guatemala, Tesliuc and Lindert
(2002) concluded that “the poor have lower resilience than the rich to the effects of shocks. The
probability of restoring household income to the level that prevailed before the occurrence of
the shock rises with income.”

In short, risk strategies tend to result in efficiency losses, and since the poor have to resort to
them more than the rich, such losses are especially borne by the poor (Rosenzweig and
Binswanger, 1993). It also means that the welfare losses caused by lack of insurance are well
beyond those in terms of fluctuations and other transient effects in consumption and other
welfare indicators. They involve permanent or chronic effects on poverty, implying
substantially higher welfare costs and lower efficiency. These efficiency losses also mean that
specific interventions could be implemented if there is no trade-off between efficiency and
equity, and if, by increasing equity (spending focused on the poor), efficiency is increased.5 (It
implies that schemes to promote insurance for the poor may well have a subsidy element that
could enhance efficiency. If providing insurance would mean that the poor can take on more
risky, but higher return activities, then in principle, these schemes may be able to pay for
themselves in efficiency terms. This makes the case for interventions to encourage insurance
with public (and aid) money for reasons that go beyond the promotion of equity (see Dercon,
2004).

(1490 words)

5
For a more detailed discussion, see Dercon (2004). For a theoretical discussion on poverty traps induced by risk,
see Banerjee (2004).

11
Scope for Insurance Provision to the Poor
The previous section analyzed the benefits of facilitating and enabling efforts to ensure that risk
and its consequences are reduced for the poor. It also identified a number of risks that especially
affect the poor (natural, health-related, economic and social risks). Indeed, there may be an
efficiency case for government action in the form of providing financing and subsidising these
efforts, beyond obvious equity arguments for supporting the poor. Still, this does not address the
question about the form these efforts should take. More specifically, is it ‘insurance’ that
provides the answer, or should other mechanisms be considered? The lack of an insurance
market is the underlying cause for risk-induced hardship, so efforts could focus on establishing
or fostering such a market. Still, this is not the typical policy answer observed. The more
traditional method for dealing with ‘risks’ has been to provide safety nets, systems of targeted
interventions focused on particular groups affected by hardship, including those produced by
shocks. In fact, this is typically the only option considered.

This focus has some justification: insurance market failures are not easily addressed. For
example, if asymmetric information is the root cause for the lack of private insurance markets,
there is little reason, in general, for the public sector to resolve problems related to information.
Similarly, even if those problems can be partly resolved, transaction costs resulting from
providing insurance to the poor are, as already discussed, likely to be high. The administrative
cost of insurance provision may become excessively expensive, with efficiency losses that may
offset any gains that may be obtained as a result of better protection against risk. Also, large
covariate and catastrophic risks are unlikely to be easily insured, unless the development of
international reinsurance markets for catastrophic risks in developing countries is fostered.
Until then, public safety net systems, financed by taxes and aid are likely to be more reliable
and sustainable. Furthermore, the advantage of simple safety nets in the form of targeted and
redistributive transfers is that they may be able to address many of the causes that trigger
poverty and hardship within one system. For example, hardship could be linked to low assets or
to a bad shock. Also, risk has a more substantial impact on the poor due to their lack of assets
and resources to cope with shocks, which excludes them from credit markets. A safety net or
other redistributive effort focusing on those with currently low income would not need to
distinguish between hardship caused by a particular shock, low assets or any other form of
exclusion from markets.

A singular focus on ‘safety nets’ has serious problems as well. First, they may not be the most
cost-effective means for addressing the problem of risk. Typically, they would only offer
support once an uninsured risk has already caused serious hardship. Secondly, they are
characterized by serious problems resulting from their functioning and inclusiveness, which is
also the case in Latin America (Lustig, 2000). Indeed, the discussion in section 2 suggests
serious shortcomings in the protection offered at present. From the point of view of the poor,
current safety nets are at best a source of uncertainty, and at worst, the poor are excluded or
support comes too late. If insurance against risk is supposed to allow the poor to engage in risky
activities that may, at the same time, increase efficiencyand have a high return, then this would
not be properly achieved by safety nets.

12
The problems related to safety nets and broader insurance provision suggest that a
complementary balanced approach that incorporates both elements would be desirable. A more
detailed analysis would be needed to understand the optimal balance of insurance-related
activities and safety nets. In fact, a number of alternative policies should also be considered in
the design of a comprehensive system of protection against risk-induced poverty. Broadly
speaking, the system should consider ex-ante instruments and ex-post measures.

Ex-ante measures would provide incentives and means for the poor to protect themselves
against hardship: better insurance products for the poor are the obvious instruments, but they
should also support self-insurance via savings, and provide access to credit in order to facilitate
asset building and properly manage those risks that might affect income. Ex-ante measures
should also focus on reducing risk itself. Ex-post measures would provide a genuine safety net,
appropriately targeted to the poor but large enough in scale and coverage to provide broad
social protection to assure a minimal and sustainable standard of living. Such measures could be
part of a more general welfare support system, or be specifically targeted to respond to risk-
related hardship.

The potential role of these complementary ex-ante measures should be stressed here. A first set
of measures involves directly reducing the risks faced by the poor, for example, policies for
basic health prevention and sanitation. Better information systems on prices and weather
conditions, , could have substantial benefits, while investments in technology could reduce
certain types of risk, with irrigation systems and drought-resistant crops being very good
examples. Indeed, this type of measures could make certain risks, that are presently too large or
covariate to offer viable insurance for, more easily insurable in a cost-effective way. They
clearly highlight the need for multisectoral approaches to deal with risk and insurance.

Other financial products can also play a role in coping with risk. Savings instruments, for
example, have been largely undervalued as an effective instrument for protection against
hardship (Dercon, 2002; Morduch, 2004). While credit provision to the poor has received much
attention, relatively little was directed to savings, even when they do present many advantages
as an area for subsidized intervention and regulation. For example, they are not affected by the
information or reinsurance problems affecting credit and insurance, and transactions costs
involved in these operations, while not negligible, are likely to be largely restricted to the
administrative handling of the savings. One of the key issues is that insurance via financial
assets may be risky, specially given the endemic risks of inflation in Latin America. Typically,
financial savings are not tailored to the poor, offer low or negative returns, and involve
extremely high transactions costs imposed on the saver. Savings should not be considered as
just a means to build a credit-worthy reputation or mobilize capital aside from the normal
economic activity of the household. The typical products are tailored to long-term deposits,
with highly punitive returns for those looking for flexible instruments to respond to unexpected
hardship.

Credit products could also help to provide better protection against risk. Credit can act as an
insurance substitute, and products for this purpose should be part of the standard portfolio of
financial instruments offered to the poor. Furthermore, credit can help to diversify the source of
income and build up assets. It can also increase income, reduce risk in income and enhance the

13
ability to cope with shocks that might affect income. Financial products for the poor should be
flexible and take into account the fact that they face substantial risks. Linked credit and
insurance contracts are one option – for example, linking credit and health insurance. This form
of insurance is not the focus of the present report, but there is definitely a need for more
research on such products.

As part of a general system of protection against risk-induced poverty, there is a clear scope for
insurance targeted at the poor. In the next section, risks that can be addressed by providing
insurance to the poor are identified in more detail, which is followed by a discussion of the type
of insurance products that could be offered. A number of successful experiences are presented
as well, focusing on strategies to deal with the particular challenges of selling insurance to the
poor. Based on this analysis, it can be argued that unsubsidized insurance for the poor is
unlikely, the only exception being life insurance. The State should still have an important role
to play in this regard, since it is its responsibility to create a regulatory environment that fosters
insurance and financial intermediation. Furthermore, evidence suggests that the best method for
offering insurance to the poor is the partner-agent model, in which an established insurer,
possibly with public sector support, cooperates with local microfinance institutions. This points
to the importance of existing informal institutions as potential agents, a point that is discussed
in the last sections of this report.

Insurance involves the pooling of risk over a large number of similar units and is most
appropriate for uncertain and high losses, which are greater than what a household can save for
or repay. When the loss and the degree of uncertainty decrease, insurance loses out to credit and
saving. Insurance therefore involves exchanging the uncertainty of large losses for the certainty
of small regular payments. Policyholders pay for the losses incurred by others, while the costs
and risk are assumed by the insurer. For less uncertain or smaller losses, savings or credit may
be more appropriate.6

Brown and Churchill (2000) suggest that there is scope for insurance provision only when the
following criteria are met: (i) a large number of similar units exposed to risk; (ii) limited
policyholder control over the insured event; (iii) the existence of insurable interest; (iv) losses
can be identified and measured; (v) losses should not be catastrophic: reinsurance becomes
increasingly difficult with increasing covariance across people (such as a hurricane or a flood);
(vi) availability of historical information on a sufficiently large number of people or property
exposed to the same risk so that probability of loss can be estimated; and (vii) premiums are
affordable. They propose a rule of thumb by which if the probability of a loss exceeds 40
percent, premiums will definitely be too high to be affordable.

There are numerous examples of insurance schemes that have been introduced without meeting
these criteria, one of the most infamous examples being the crop insurance programs introduced
in the early 1980s in different parts of the world. Many of the criteria included above apply to
poor and rich insurance clients. However, some of them make it particularly difficult to

6
This feature may also explain why the poor in Latin America may be unwilling to purchase some of the existing
‘formal’ insurance products available and instead prefer to rely on ‘autarkic solutions’, including self-insurance,
since the lack of appropriately targeted and designed products would make existing products relatively too costly for
the poor, possibly outweighing the benefits.

14
profitably insure the poor. The need for premiums to be economically affordable often means
that the policy portfolio cannot actually be covered by contributions, or that insured amounts
are so small that they make little difference to the vulnerability of the poor. SEWA, an Indian
health and life insurer, is a case in point, with payouts so low that they only cover about 10
percent of losses caused by illness-related shocks. Insurance to the poor is traditionally fraught
with high per-unit transaction costs, because premiums need to be small and collected
frequently, while the total amounts of policies are also small. Problems such as moral hazard
and adverse selection are not necessarily more damaging among the poor, but the higher
transactions costs in dealing with them may mean that these issues make insurance unprofitable.
Nonetheless, a number of small-size (microfinance) institutions already cater to the poor. Their
successful experiences may help to develop some best practice guidelines for potential entrants
into the small-scale insurance market that want to target the poor.7 Some of these lessons are
discussed in the fourth and fifth sections.

A key lesson is that ex-ante measures, in the form of a savings, credit and insurance system,
may provide substantial protection to the poor, but ultimately they cannot fully insure
individuals and families. In short, some ex-post measures that entail transfers to those affected
by uninsured risk would still be necessary as part of a comprehensive system to protect the poor
against risk. Insurance products for the poor need to be simple, insuring only specific, highly
observable risks with measurable losses, while high-risk groups may need to be excluded by
design for the scheme to be sustainable.

All self-protection strategies require some outlay beforehand, and self-insurance fails if shocks
occur in successive periods. Credit as a substitute for insurance may not be available either.
Certain highly covariate and rare events are very difficult to insure. This means that some
‘natural’ risks, such as catastrophes, may not be easily covered by a pure insurance system.
Other risks require that other types of measures be applied and market-based insurance products
are unlikely to be the most sensible or only response. ‘Social’ risks such as crime or
enforcement of property rights are examples. While it is possible to design products that insure
against the consequences of these risks, they only address part of the problem.

But even if there are clear limits to insurance provision for the poor as a solution for their
vulnerability to risk, insurance is definitely an option worth focusing on. In particular, life and
health insurance, as well as forms of property and asset insurance are within the possibilities,
and even insurance against some covariate risks, such as drought or, in general, weather
insurance. In the next few sections, a strategy to implement such insurance schemes is
discussed in more detail.

7
The survey by Brown and Churchill (2000) provides a number of examples.

15
Implementing Insurance for the Poor

Some key issues pertaining to insurance management need to be addressed when implementing
insurance programs for the poor. This section addresses institutional arrangements and issues
such as financial management, premium calculation, distribution of services and reinsurance,
with a particular focus on targeting the poor.

It is paramount that agents involved in insurance schemes have very close contact with the
poor. This is unlikely to be achieved by either government agencies or by standard private
insurance providers. As such, institutions with close links to grassroots organizations or NGOs
may be ideal agents, for example, microfinance institutions (MFIs), which are relatively
widespread within developing countries. But, since purchasing insurance involves a payout only
in the case of an adverse shock, it is critical that insurance customers clearly know and
understand the benefits they are entitled to. This requires a simple and clearly stated policy,
swift processing of claims and careful financial management of the insurance portfolio by the
insurance provider. To inspire trust among the clientele, adequate reserves need to be held and
financed through underwriting, reinsurance and investment. To be financially viable, insurers
need to have a sufficiently diversified investment portfolio. This is something that MFIs or
other institutions working closely with the poor may often find hard to achieve.

A partner-agent arrangement, in which a local institution or the MFI undertakes only the
distribution of insurance services, linked with a private or possibly public sector insurance
provider, may therefore be more appropriate when targeting poor customers. One of its
advantages is that it eliminates agent risk and allows the institutions involved to focus on their
particular strengths. It also allows local institutions and MFIs to offer greater benefits to
policyholders at a similar cost. The most important drawback of this model is the limited
availability of potential partners. Fostering these relationships is an issue that public policy
should address, by providing a clear institutional and regulatory environment.This point is
discussed in further detail in the sixth session. Within the context of a partner-agent
arrangement, mutual insurance funds may overcome some of the resistance against insurance,
since they mimic features of informal insurance arrangements in which funds are often
distributed back to members at regular intervals. Exiting informal arrangements may, however,
become a part of an MFI’s established set of procedures.

Turning to the issue of premium setting, most of the existing insurers surveyed by Brown and
Churchill (2000) calculated their premiums either in house or by partnering with an established
insurer to gain access to the required expertise. Brown and Churchill also found that MFIs that
cooperate with established insurers are usually able to offer coverage at better prices. IFOCC in
Peru searched for partners with the actuarial expertise they lacked, but they were unable to find
an established insurer willing to provide a product to the low-income market. Instead, they used
their own simple calculations based on historical mortality statistics within their credit portfolio.
ASA in Bangladesh, however, followed a different and far more risky approach and based their
premiums on customer demand, starting out with very high premiums on their mandatory
insurance policy. Numerous complaints were received from their clients, so premiums were
then lowered successively until complaints stopped. While this ensures that clients are able to

16
afford premiums and are satisfied with the rates offered, it obviously entails a higher risk than
the calculation of premiums based on actuarial principles.

As Rutherford (1999) points out, one of the most important demands the poor make on their
financial services is easy access and regular small payments, which impose the necessary
payment discipline. An agency employing home service distribution and collecting premiums
on a weekly basis would be well suited to the needs of low-income households, although it may
incur high transaction costs. Integrated distribution, as practiced by SEWA in India, where life
insurance is distributed through already existing fixed deposit accounts, could help to curb these
costs.

Reinsurance is one element that is almost completely absent in micro-insurance and similar
insurance institutions focused on the poor . One of its many benefits is that it can improve the
ability of insurers to grow, helps to stabilize financial results, protects against catastrophic
losses and improves underwriting expertise. Reinsurance in low-income markets can also open
up markets for some of the large-scale covariant risks such as many natural disasters (Skees et
al., 2004). However, to attract reinsurance, it is of critical importance that primary insurers have
sound pricing policies and control against abuse. According to respondents in the Brown and
Churchill survey, all partner institutions in partner-agent arrangements and some cooperative
insurers were likely to have reinsurance contracts. However, few of the MFIs and other smaller
organizations in their study have reinsurance, which leaves them highly exposed to sudden
increases in claims and prevents them from having access to a potentially valuable source of
expertise.

17
Insurance Products for the Poor
This section focuses on four types of products, their strengths and problems. In particular, it
discusses life, health, property-related and weather insurance. Life insurance is a relatively
low-risk product and the one most widely available to the poor. Most existing schemes offer
mandatory term-life insurance as part of an outstanding loan or savings account, thus
minimizing their distribution costs. The majority of the institutions surveyed by Brown and
Churchill (2000) also limit coverage to only those policies that are not in arrears when the
policyholder dies. Certain causes of death are also excluded, for example, AIDS. While such
life insurance for outstanding loans with simple terms works reasonably well, it is important to
note that it often protects the MFI more than the client, since many MFIs would otherwise write
off losses due to death regardless of the availability of insurance.8 Additional benefits, such as
insurance tied to savings rather than credit, and stand-alone term and endowment policies offer
coverage that is more focused on the needs of the policyholder rather than the institution.
ACODEP’s life saving insurance in Nicaragua is a good example, since their policies provide a
benefit that is double the amount held in savings to the client’s beneficiaries.

In theory, endowment life insurance can provide low-income households with complete
protection against death risks and, through a saving and loan component, partial insurance
against other risks and needs during their life cycle. Delta Life in Bangladesh has been a
pioneer in marketing this kind of product to the poor. However, Delta Life has experienced
difficulties in managing its loan portfolio, potentially jeopardizing its ability to pay out the
promised bonuses as the policies mature. Such a product requires that larger reserves be held
and more sophisticated actuarial expertise in its management. Still, Delta Life’s case is an
interesting one, and the promotion of such products could be worthwhile. But, once again, it
should be stressed that a partner-agent model with a sufficiently strong partner is the best
option.

An important question when offering insurance to the poor is whether this can be done
profitably. All life insurers surveyed by Brown and Churchill are profitable, but it was evident
that institutions with the benefit of access to actuarial expertise in calculating premiums appear
to offer greater value for lower premiums. Reserve holdings differed greatly from 1.9 times the
level of claims to several hundred times for very similar policies. Ten to twenty times annual
claims may be an advisable reserve holding. All insurers had expense ratios well below 60
percent (claims expenses + operating costs / annual premium revenues). For example, IFOCC
(Peru), used 44 percent of its premium income to cover claims and, just 5 percent to cover
operating expenses (due to integration within its credit operations). Thus it seems reasonable
that various forms of outstanding balance insurance can be profitable in low-income
communities. The following table, taken from Brown and Churchill (2000) gives some
preliminary performance guidelines for institutions offering life insurance.

Insuring health risks poses different and more complex challenges for providers than offering
life insurance outright. Insurance of health risks may suffer from adverse selection and moral

8
It is in fact plausible that if MFIs used reinsurance properly, the cost of mandatory life insurance linked to
outstanding loans would be much lower for customers than it is at present. In many ways this form of insurance is a
cost that derives from inefficiency, and not a benefit for customers.

18
hazard and usually entails the provision of health care. To avoid moral hazard and adverse
selection, various mechanisms are in use. For example, two Ugandan health insurance
institutions, UHC and FINCA Uganda, require that more than 60 percent of the members of a
group agree to enroll before coverage is extended to a cooperative, trade union, MFI, or to a
village bank. COHI Benin charges a small initiation fee to new members and has a one-month
waiting period after receiving the first premium before policyholders can receive health care
coverage. To control for escalating treatment costs, some insurers implement mandatory
reference systems that encourage patients to use the lowest cost treatment facility first. Few of
the institutions surveyed required formal underwriting before a family purchases a policy. But
some providers have not designed their schemes properly.

To provide the right incentives to the service provider, various payment mechanisms can be
used.When good quality control is in place, one form of payment that works well is capitation
payment: the insurance scheme pays the provider a fixed amount per member and the provider
agrees to provide care, as defined in the policy, for any member who needs it during the period.
By paying for the number of people instead of the number of services offered, the scheme
reduces the provider’s incentive to provide more, possibly unnecessary services. ASSABA in
Guatemala used this scheme. However, it also places risk solely on the provider if there is
excessive usage and the provider is unwilling to agree to such a scheme. Therefore, fee for
service may be more practical. Alternatives are fixed cash subsidies given to each member to
pay for health expenses regardless of actual claims.

Three different methodologies are employed to fund health-care services provided for by their
policies: salaried service provision, dedicated health-care facilities and indemnity coverage.
Naturally, there are strengths and weaknesses to each of these approaches. Salaried service
provision, whereby health services are provided by staff working exclusively for the health
plan, often provides the most convenient access. ASSABA used this system. However, many
types of health care services cannot be provided in a cost-effective manner by salaried
personnel serving only members of a certain health plan. If they are provided locally, dedicated
health-care facilities can offer convenient quality care, but this approach requires a higher
degree of administration to monitor the services provided and how members use services
covered by the policy. Indemnity coverage reduces administrative costs for the health plan, but
gives it less control over the quality of care. Also, it may not provide effective coverage for
members who cannot afford to pay for services up front and receive reimbursement later.

Unfortunately, health insurance schemes targeted at relatively low-income customers are often
liable to serious losses. For their survey, Brown and Churchill (2000) had access to financial
information for four providers. They found that three out of those four providers were not
covering their costs. One had expense ratios of 216 percent, which reflected the challenge of
profitably offering health care insurance to low-income households. Only COHI (Benin) was
able to avoid losses, since it only offers very limited coverage with many exclusions and
restrictions.

Another product is property insurance – including against fire or theft. Few providers have
experience with type of insurance. This is unfortunate as property loss is a big risk especially
for the urban poor in Latin America. A key issue is likely to be insufficiently defined property
rights and titles that are difficult to enforce. If assets are identifiable, their value is likely to be

19
relatively low, which would increase valuation costs relative to the value of the policy. The
experience of La Equidad in Colombia may nonetheless be helpful when designing new
products. La Equidad offers comprehensive coverage on many types of risks after conducting
substantial market research about the needs of its clients. As a consequence, its property
insurance is not tied to an outstanding loan. Policyholders themselves determine the value of the
asset. Since the premium is tied to the insured value of the asset, policyholders have an
incentive to state the true value. This mechanism simplifies the sales process greatly. La
Equidad determines premiums according to the risk exposure of their clients and their type of
business: service, trade related or manufacturing.

In the case of property insurance for the poor, premiums are not adjusted according to the
preventive measures that might be in place, most likely because of obvious enforcement
problems. Instead, La Equidad offers regular group meetings for policyholders to train them
about basic preventive they could take. To prevent against moral hazard, two mechanisms are
used: deductibles and claims inspectors. However, all insurers indicated that sending inspectors
was too expensive for small claims. There is little information on the financial performance of
property insurance since it is so rare. Also, and more than with other types of insurance, low-
income households appear to be slow to embrace the idea of purchasing insurance on their
valuable assets. This may be because property risk is less certain, in contrast to death or the
health problems that clients may have to deal with eventually.

Another insurance product, which is not often offered but is receiving much attention, is
weather insurance. It is receiving much attention (see e.g. Skees et al., 2004). Risks in
agriculture that relate to drought or other weather events remain some of the most important
ones facing the poor. In general, systems to insure crops have generated high costs and have,
however, failed. So there is a continued interest in finding alternative insurance mechanisms.
Many factors are responsible for those failures, but moral hazard and the high costs of the loss
verification process after specific weather events are key in this regard. The high covariance
involved in agricultural risks and reinsurance compound these problems.

However, there have been innovative theories for the design of systems that may not be so
liable to some of these problems. The idea is to supply insurance based not on the assessment of
crop losses, but on weather indexes. Given the observability of weather indexes, such a system
could avoid moral hazard and adverse selection issues, and in general save on transactions
costs. The recent evolution of international markets for unusual and catastrophic risk suggests
that reinsurance by international markets may become feasible (Skees et al., 2004).

It has been suggested that weather-indexed bonds could encourage agricultural insurance
systems to start offering services to poor and small farmers. In this case, problems of
asymmetric information are largely resolved and, for example, insurance could be based on
small mutual insurance groups that can obtain rainfall reinsurance through these bonds. The
bonds could be priced for reinsurance, since historical data on rainfall are available and they
could even be traded internationally. Even without reinsurance by international markets, there is
still a case for reinsurance through governmental budget and assistance: the fact that an
instrument may be available that can be provided at low transaction costs to poor farmers
supports the idea of subsidizing for equity, and possibly efficiency, reasons.

20
One should nevertheless be careful not to idealize the benefits of rainfall insurance. To reach
the poor, substantial transactions costs will surely be involved, while, to be effective, the
correlation between rainfall measured at reliable stations and local yields will need to be high.
The latter is not necessarily guaranteed since rainfall stations are not very common in
agricultural areas with low potential and limited commercial farming interests. Also, the
sustainability of the scheme will depend on the relative predictability of certain events. While
they affect pricing, some weather phenomena, such as global warming or El Niño, are not well
understood. The high covariance involved will require premiums with high frontloading
(adding an extra sumto the premium to handle the non-zero probability of the scheme failing),
making insurance more expensive for the poor. Overall, however, such new products deserve
experimentation and further analysis to understand the possibilities for effective delivery of
weather-related insurance to the poor. Indeed, programs being implemented in Mexico for the
use of weather-based indexes will provide helpful insight, as will current experimentation in
other countries, such as India (Skees et al., 2004).9

9
Price insurance is not explicitly considered in this paper, even though forms of price stabilization have often been
implemented for their insurance value, while futures contracts effectively provide insurance to farmers in an
increasing number of countries. Pure price insurance schemes are less common, but they might yield good results if
they are properly designed. Since price shocks are highly covariate some of the issues related to designing and
delivering insurance are similar to those related to weather insurance. Collier (2004) discusses the possibility of
price insurance offered to producers of internationally traded commodities, whereby, given its private and social
(growth) benefits, donors could underwrite this insurance and subsidize administrative costs. Collier argues that the
benefits of such price insurance schemes may well be larger than weather or other quantity insurance schemes.
Experimentation with these types of schemes would be highly beneficial.

21
Regulation for Insurance Provision to the Poor
The previous section identified a number of products that could be successfully offered to the
poor. The partner-agent model was identified as the best mechanism for these products to
effectively reach the poor. . This model takes advantage of the strengths of the different parties
involved in insurance provision to the poor. The ‘partner’ is an established insurer, with
experience and interest in broadening its insurance portfolio to include products suitable for the
poor. In order for it to be a successful operation, it will need to design contracts that provide the
appropriate incentives for the insurance arrangements to be sustainable, while also being
credible to agents and its clients. Earlier, the argument was made that the problems related to
risk-induced poverty traps implied a preference for subsidized insurance, efficiency being the
main argument. This does not mean that its implementation is straightforward: the case for
subsidies or other government intervention opens in itself opportunities for rent-seeking on the
part of the ‘partner’ toward the government, not least given the political economy consequences
of a scheme focused on service provision to the poor. The ‘agent’ will need to be provided with
the appropriate incentives to maintain the sustainability of the portfolio. These agents are likely
to be financial institutions with close contacts with the lower-income segments of the market.
Microfinance institutions have been established with this purpose, although their involvement
in the insurance segment has been limited. Existing microfinance institutions could be
encouraged to branch out into more widespread insurance, or assistance could be given to
certain microinsurance providers for them to enhance their products.

There is substantial scope for the government to effectively support the insurance market
serving the poor. A favorable policy environment can support the proliferation of insurance
services among the poor by facilitating the establishment of local (micro) finance institutions,
and making insurance provision to the low-income segment of the market more attractive to
established insurers. The strategy is unlikely to involve large-scale subsidies, but government
spending will need to be directed toward establishing the necessary infrastructure, institutions
and regulatory environment to promote this segment of the market. Unfortunately, such a policy
environment does not exist in most parts of the world, and, in fact, some of the existing
regulations actually present a bias against the use of finance and insurance products targeted to
the poor (see Dercon (2005) for a further discussion).

Local Institutions and Insurance Provision to the Poor
One should however be careful not to idealize the ability of MFIs to easily and effectively
provide insurance to the poor. While they may be a crucial intermediary for established insurers
to enter the low-income segments of the market, their own ability to effectively reach the poor
should not be taken for granted. Their record of reaching the poor is not always impressive.
Formal institutions have typically difficulties in reaching poor communities and individuals,
who end up being largely dependent on their own risk-coping strategies, even if seemingly
appropriate alternatives are available. Any program aimed at including the poor should be
sensitive to these problems.

22
One route to consider would be trying to mobilize existing ‘informal’ savings and insurance
institutions to assist in ‘crowding in’ financial services, including insurance, into these
communities. A plethora of local informal institutions run by their members such as Rotating
Savings and Credit Associations (ROSCAs) and Accumulating Savings and Credit Associations
(ASCAs) exist, which provide an opportunity for credit, saving and insurance, while the
existence of more ‘informal’ groups – such as mutual support networks and funeral
associations— have been identified throughout the world. The key issue is whether they can be
integrated into more formal insurance projects as potential local agents in a partner-agent
framework with the following hierarchical structure: an established insurer that contracts a
microfinance institution, which in turn involves a local ‘informal’ institution dealing with the
clients. The key advantages of mobilizing these local informal institutions are their local
expertise, reputation and informational advantage on the local community.

It is worth to carefully discuss how this may work. Two points are crucial here. First, it may be
that offering insurance or other products from outside the local community can be done more
effectively using these local institutions, resulting in net benefits to the community. However, it
may also be that the introductions of outside agents may crowd out any local ‘informal’
insurance or other beneficial interactions. These incentives need to be discussed, focusing on
the overall benefits of the scheme.10 Note that these concerns could be present even if the model
is simply an agent with close contact in the local community (the MFI) directly trying to
introduce formal insurance on behalf of the established insurer, although in the discussion
below the focus is on the existence of informal but explicit interactions between people at the
local level, such as in the form of informal risk-sharing.

Several studies examine the possible interaction of explicit incentives— those that can be
externally verified and thus become the basis of a contract — and implicit incentives in
principal-agent contracts. This can help to understand how credit contracts could be designed in
the presence of local informal risk sharing. Conning and Kevane (2004) discuss the case of
obtaining a loan to undertake a risky project whose success — observed by the financial
institution — depends on the amount of effort (unobservable to the outside financial institution)
that is exerted by the borrower. As with all problems of moral hazard, any contract that is to
implement diligence must offer the agent a higher expected utility under project success than
under failure, so as to give him an incentive to want to raise the probability of success via
diligence. For this to be the case, the villager, who is assumed to be risk-averse, must be made
to bear the risk. The feasibility of such a contract between the villager and the financial
institution thus depends on the cost of diligence. Conning and Kevane show that if agents in the
village have the ability to enter into side-contracts for the purpose of mutual insurance which
are based on observed effort, the set of feasible contracts is increased since the side-contract can
provide more risk-smoothing to the agent who took out the loan without disrupting incentives
because the other agents' monitoring keeps the latter diligent in circumstances where the
individual incentive compatibility constraint would not be satisfied. This is an example where

10
It is sometimes argued that crowding-out of local institutions, such as credit and insurance systems, should be
avoided at all cost. However, as Morduch (1999) argued, the key issue is the overall welfare benefit of the scheme:
the benefits to individuals from ‘formal’ financial intermediation should outweigh the costs of the disappearance of
informal mechanisms. Note however that there may be distributional effects as well (other people benefit from those
that lose), which require careful consideration, not least if the poor suffer more.

23
local informal insurance can crowd in outside financial intermediation. This rests on the
assumption that monitoring is costless, that local agents have better information than outside
agents and, most importantly, that they do enter into an insurance side-contract.

Literature on self-enforcing contracts however shows that this need not be the case. Since
informal insurance is not enforceable, contracts have to be self-enforcing, which requires that
the one-time gain from deviation is smaller than the expected benefit of continuing in the
arrangement. This means that informal insurance is not always feasible and furthermore its
feasibility is affected by the pay-off from reneging on the agreement, which in turn is affected
by the availability of outside financial intermediation. However, even if the pay-off from
reneging is increased through the access to outside credit, this may not necessarily lead to a
break-down of existing informal insurance arrangements. Introducing an outside safety net or
other form of insurance that is well targeted not only increases utility in autarky but it also
affects the distribution of wealth in a community, hopefully making it more equal and
facilitating reciprocal transfers, where before income differences would have been too large to
make risk-sharing possible (Coate and Ravallion, 1993). Even better results can be achieved
when the availability of outside financial services is made conditional on participation in a local
informal risk-sharing arrangement (Attanasio and Rios-Rull, 2000). In other words, this implies
that there could be ways to increase informal risk sharing by extending formal financial
services, including insurance.

While the above has focused on bilateral risk-sharing, local informal institutions where they
exist usually comprise larger groups (albeit rarely the whole community) and often hold
substantial amounts of assets.11 Genicot and Ray (2003) in fact show that these informal groups
will always be of limited size because of the requirement for self-enforcing arrangements in the
absence of legally binding contracts. This opens up the possibility of offering reinsurance to
such groups. This would have a direct beneficial effect of reducing the claim variance an
informal institution faces and, since the size of such groups is constrained by the possibility of
deviation during periods of illiquidity, an indirect benefit may be that larger groups achieve
stability thus increasing diversification against risk within the informal institution. An added
benefit of offering reinsurance to existing groups is that it does not change the payoffs in
autarky but only affects those of remaining in the group, so that there is strict complementarity
between informal and formal insurance. Furthermore, funds of such informal institutions may
be used as collateral to crowd in loans from outside financial institutions as suggested by
Conning and Kevane (2004). In short, these theoretical arguments suggest a number of avenues
in which extending financial services such as formal insurance to local communities and
through local institutions could have substantial benefits. But all these models include
restrictions on the type of contracts and arrangements between MFIs and the local community
that are in fact possibilities for improving welfare. To put it simply, schemes may still result in
overall negative welfare effects. Furthermore, if there are different levels of wealth among
villagers, the benefits and costs may well be borne by different people, adding further
complexity to the evaluation. In any case, it points to the need for a careful design of insurance
products and their delivery that should take account of the functioning of existing local
mechanisms. The analysis above suggests that sensible directions for integrating local informal
schemes into broader insurance provision to the poor could include offering group policies or
11
Burial insurance, which is a simple type of life insurance, is often organized in this manner.

24
reinsurance to existing groups, using their funds as collateral for loans, while also making use
of their local expertise in reducing transaction costs and asymmetry of information.

Conclusions
The poor face substantial risk, in the form of natural, health, social and economic risks, and are
also more likely to be affected by them. In general, the poor use sophisticated mechanisms to
cope with this risk, which is not enough. The welfare losses are substantial: the coping
mechanisms themselves come at an additional cost in terms of long-term welfare. As such, risk
and how the poor respond to it contribute to the persistence of poverty. There is a clear need for
further policy work to reduce risk and its consequences, as current systems do not provide
sufficient protection. Indeed, there may well be an efficiency argument for providing subsidized
insurance and protection, given risk-induced poverty traps.

This study has argued for fostering insurance provision, not as panacea to solve all problems,
but as part of a comprehensive system. The current focus on ex-post measures in the form of
some safety net is not cost-effective or sufficient to reach the poor. Other components of such a
system would be ex-ante measures to stimulate and protect self-insurance through savings,
reducing risk and fostering credit for the poor as a form of insurance and to allow a stronger
asset base to grow out of persistent vulnerability to risk. These efforts need to be supplemented
by a careful and well-designed safety net since some risks should not be addressed by ‘ex-ante’
insurance-related mechanisms – examples are certain covariate economic or catastrophic risks.
A high proportion of risk, including economic and social risk, is also largely man-made, and
reducing their impact requires actions to address the causes of these risks – inflation, crime or
waste-related risks are examples. Providing only protection against the consequences of these
risks is unlikely to be cost-effective.

In terms of the basic institutional setup for insurance provision, the partner-agent model appears
to be the most suitable, so that an established insurer (the partner, from the private sector,
possibly in partnership with the public sector) links up with an institution with local financial
connections, such as a microfinance institution (MFI). The advantage is that this would include
a mechanism to provide easy access and terms to the poor, while costs are reduced and
sustainability is protected by reinsurance and contracting with an established insurer. Judging
from case studies, it appears that a number of products might be suitable for promotion,
including life, property, health, weather or price insurance, possibly linked with credit. By its
covariate nature, weather or price insurance requires mechanisms of reinsurance either
internationally or through budget or aid, but much progress has been made in recent years to
develop workable models.

One should be cautious about the likely success of these schemes. In terms of types of
coverage, the experience of existing insurers catering to the poor shows that it is difficult to
offer profitable comprehensive coverage to low-income households. In part, this can be
explained by the financial capacity of clients and the lack of opportunities for diversification.
Term life insurance is the most sustainable type of insurance, but the support of governments,
donors and NGOs is necessary to branch out into other profitable products. Product features
should include group policies, mandatory insurance and incentives to cope with moral hazard

25
and adverse selection, for example by rewarding members who do not submit any claim during
the year.

While subsidized insurance for the poor can be an attractive option on efficiency grounds, an
important role for the government would be to establish a more effective regulatory framework
to foster the establishment of microinsurers at the local level, while maintaining overall stability
and credibility of the entire financial system. While relaxing entry requirements for MFIs to
enter the insurance market may be beneficial, incentives should be also provided so that MFIs
partner with established insurers, through the partner-agent modality.

MFIs can easily and effectively provide insurance services to the poor, but it is important to
acknowledge the presence of local insurance and other finance-related institutions. There is a
clear scope for involving these institutions as intermediaries in insurance provision, since they
possess knowledge of local conditions and an established reputation.

Finally, objectives should be clearly defined when providing more insurance to the poor.
Uninsured risk means that poverty is perpetuated, with the possibility that a risk-induced
poverty trap might occur. More insurance, as part of a credible comprehensive system of ‘social
protection,’ should allow the poor to sustain their assets and to enter into more profitable, risky
activities. In short, it would allow the poor to focus on long-term strategies to get out of poverty

Of critical importance are the credibility and sustainability of insurance provision as part of a
broader social protection system . The issue is not who should provide the services as part of
the system: different agents, including NGOs, community organizations or the private sector
could play a significant role. There is a key role, however, for the government in the
development of and support to an appropriate regulatory and institutional framework for such
programs, and sustainable and transparent institutions to monitor these activities.

This issue cannot be underestimated. Often, institutions in developing countries are not
transparent or sustainable, and therefore well-intentioned measures may lack the credibility and
public support to succeed. Credibility cannot be easily acquired, and governments face an uphill
struggle in this regard. The important role for aid and the donor community is to support and
ensure the enforcement of these measures so that the benefits of insurance products targeted to
the poor can be improved by enhancing their long-term effect on poverty.

28
Jannson, Tor and Mark Wenner. 1997. Financial Regulation and its significance for
Microfinance in Latin America and the Caribbean. Sustainable Development Department
working paper. Inter-American Development Bank. Washington D.C.

Holzmann, Robert and Steen Jørgensen. 2000. .Social Risk Management: A New Conceptual
Framework for Social Protection and Beyond. Social Protection Discussion Paper Series
no. 6. Washington D.C.: The World Bank.